Understanding the Impact of Connelly v. United States on Business Planning and Estate Tax

By: Karen Fierro

Partner, Tax

On June 6, 2024, the U.S. Supreme Court issued a landmark ruling in Connelly v United States, a decision with far-reaching implications for estate tax valuations and business planning. This pivotal case has reshaped how life insurance proceeds are factored into the valuation of closely held corporations upon a shareholder’s death.

If you are a business owner, estate planner, or legal professional, understanding the nuances of this case is critical. The decision affects how buy-sell agreements funded by life insurance are structured and could lead to higher estate tax liabilities for business owners’ heirs.

This blog breaks down the main aspects of the Connelly v United States decision, its implications for estate and tax planning, and actionable considerations for business owners and professionals.

Key Takeaways from the Connelly v United States Decision

What Was the Case About?

At the heart of the case was a dispute over how life insurance proceeds used to fund the redemption of shares from a deceased shareholder should be treated when calculating the fair market value (FMV) of the business for estate tax purposes.

The 8th Circuit Court had ruled that life insurance proceeds—often considered a means for liquidity to redeem shares—must also be factored into the fair market value of a business. The Supreme Court upheld this ruling, which effectively increases the valuation of the business for estate tax calculations.

Previously, life insurance proceeds were excluded from FMV when tied explicitly to buy-sell agreements. The court’s ruling, however, emphasizes that such proceeds can no longer be automatically excluded, regardless of their purpose.

Why Is This Case Significant?

The decision changes the rules governing how buy-sell agreements funded using life insurance are viewed in tax planning. Closely held corporations and family businesses, in particular, face the risk of significantly higher estate tax liabilities—potentially leading to financial strain on heirs and business continuity challenges.

The ruling suggests a broader view of corporate value, where liquidity benefits gained through life insurance are seen as an integral part of the entity’s overall worth at the time of valuation.

The Implications for Business Owners and Estate Planners

1. Impact on Estate Tax Liabilities

Under current federal estate tax laws, the value of an estate exceeding the exemption threshold is subject to significant taxation. With the Supreme Court ruling, including life insurance proceeds in FMV calculations means many estates may cross the exemption threshold more easily, leading to higher taxes.

For example, consider a family-owned manufacturing company valued at $15 million. If $5 million in life insurance proceeds were previously excluded as part of a buy-sell agreement, the taxable estate would now be assessed at $20 million—leading to substantial additional estate taxes.

2. Redefining Planning for Buy-Sell Agreements

Buy-sell agreements are commonly funded with life insurance, ensuring the business has liquidity to buy back a deceased owner’s shares from their estate. The Connelly ruling forces business owners to reconsider these plans to account for the impact on estate valuation.

Without proactive restructuring or alternative planning, heirs could be left with a significant tax liability, jeopardizing the financial health of the company and potentially requiring the sale of assets or even the company itself to cover the tax bill.

3. Uncertainty for Closely Held Corporations

For closely held corporations and family businesses, this decision heightens the need for advanced valuation strategies that consider insurance proceeds as a part of FMV. Tax professionals and planners must educate business owners about this critical shift and take action to mitigate potential risks.

Actionable Insights for Business and Estate Planning

Plan Proactively to Minimize Estate Tax Exposure

Businesses should work closely with tax professionals to reevaluate estate plans in light of the Connelly decision. Consider the following strategies to reduce potential tax exposure:

• Revisit Buy-Sell Agreements: Amend buy-sell agreements to include provisions that minimize the impact of life insurance proceeds on FMV. Consider structuring agreements that rely less on direct valuation impacts.

• Establish Irrevocable Life Insurance Trusts (ILITs): ILITs can remove life insurance proceeds from the taxable estate, shielding those proceeds from FMV altogether.

• Explore Alternative Liquidity Solutions: Look into company reserves, deferred payouts, or other funding mechanisms to mitigate the reliance on life insurance.

Collaborate with Valuation Experts

Given the court’s focus on FMV, working with valuation experts is essential. They can provide accurate appraisals of a company’s value while factoring in the nuanced effects of the Connelly ruling.

Consider State-Level Impacts

Estate taxes vary state by state. Businesses operating in states with stricter estate tax rules should evaluate the dual impact of federal and state-level taxation post-Connelly.

Questions Estate Planners and Businesses Must Address

1. What is the current value of the business, and how do life insurance proceeds affect that valuation?

1. Are all buy-sell agreements structured optimally given the new ruling?

1. How can alternative tools, such as trusts, be incorporated into the estate plan?

1. What strategies can mitigate the liquidity challenges of increased estate taxes?

What Lies Ahead for Estate and Business Planning?

The Supreme Court decision in Connelly v United States serves as a critical reminder of the complexities surrounding estate planning in dynamic tax and legal environments. For business owners, failing to act on these changes could lead to significant financial challenges for their heirs, including the potential breakup of family-owned enterprises.

Proactive planning is now more important than ever. Business owners, legal professionals, and tax advisors must adopt a collaborative approach to reevaluating buy-sell agreements, implementing trusts, and exploring other methods to mitigate the ruling’s impact.

Final Thoughts

The Connelly v United States decision may have introduced new challenges, but with proper guidance and planning, these challenges can be navigated successfully. If you’re unsure about how this ruling impacts your business, reach out to a Wiss team member today. By engaging with trusted tax and estate planning professionals, you can protect your legacy and ensure a smoother transition for the next generation.

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